Analysts regularly attribute record bank profitability in recent
years to the significant growth of noninterest income, the revenue
that banks earn from areas outside their lending operations. In
addition to its growth, noninterest income over the last decade
has been characterized by a shift in sources from charges on deposit
accounts, for example, to fees for mortgage servicing or sales of
mutual funds.

These trends are partly explained by new technologies and opportunities
available to banks, but the "unique features" of noninterest income also explain them. Most importantly, banks that increase noninterest
income could reduce risk; the increased noninterest income could
lead to more diversification. Of course, noninterest income is no
panacea and claims about its stability may be exaggerated.

Noninterest income: What is it
and where does it come from?

Any income that banks earn from activities other than their core intermediation
business (taking deposits and making loans) or from their investments
is classified as noninterest income. This type of income is often referred
to as "fee income" since fees constitute the majority of noninterest income.
Banks report this income to regulators in five broadly defined categories
summarized in the accompanying table.

Average Growth Rate per Decade

Two new trends in noninterest income

Over the last 20 years noninterest income has transformed from
a supportive role into a major contributor of bank revenue. The
growth of noninterest income has been accompanied by a significant
change in the sources of such income.

Growth

Noninterest income and interest income grew at similar rates from
the 1950s through the 1970s. From the beginning of the 1980s, the
growth rates diverged and for the past 20 years noninterest income
has grown on the national level at roughly twice the rate of net
interest income. As a result, the share of net revenue attributable
to noninterest income has increased from 20 percent in 1980 to over
40 percent today.

The rapid growth in noninterest income shows no signs of slowing.
Noninterest income has grown at double-digit rates for the last
three years and surged ahead almost 19 percent last year, compared
to only a 5 percent increase for interest income. Both large banks
(those with assets greater than $100 million) and small banks have
experienced the shift toward more fee-oriented businesses, although
small banks have registered consistently lower levels of noninterest
income. (Noninterest income accounted for 43 percent of large banks'
revenue in 1998 and 23 percent of small banks' revenue, compared
to 27 percent and 15 percent in 1984.)

Change in composition

The composition of noninterest income has also changed markedly
during the last five years. Fee income has become the dominant source
of noninterest income received by banks, replacing the traditional
mainstays of service charges and income from trust activities. Fee
income has accounted for most of the growth in noninterest income
since it was first measured in 1991. Almost 50 percent of the increase
in noninterest income nationally is due to heightened levels of
fee income.

The change in composition is not limited to large institutions.
Small banks have also focused more of their efforts on generating
fee income over the past eight years, which currently accounts for
over 40 percent of their noninterest income, the same percentage
as large banks. Small banks still earn more from service charges
than they do from generating fees, and the gap between fee income
(the largest source of noninterest income) and revenue from service
charges and trust activities at large banks has been narrowing recently.

Fee income at large banks reached its highest level in 1995, when
it was responsible for over 50 percent of noninterest revenue. Since
then it has grown around 7 percent per year, while service charges
and trust income have grown at over 20 percent.

Why the trends in noninterest income?

There are at least two explanations for the recent trends in noninterest
income. First, technological and regulatory changes opened up new
sources of noninterest income. Second, noninterest income was believed
to provide favorable attributes to a bank's revenue stream.

New technologies and regulatory climate

All the examples under fee income in the table reflect technological
changes over the last decade and a half. Asset-backed securitization,
for example, has been in existence for 15 years and only took off
within the decade. Likewise, the explosion of ATMs is a relatively
recent phenomenon made possible by advances in communication and
computing power. Even the massive size of modern-day mortgage lending
and servicing operations at banks reflects significant advances
in financial technologies. Most generally, the advances made in
computing and telecommunications make it possible for banks to directly
market fee-related services in a manner not previously possible.

Other of these revenue possibilities for banks reflect a relaxation
of regulatory constraints. Banks have more freedom to offer nontraditional
products today than they did a decade ago. Moreover, government deregulation
has opened up the banking industry to previously unfelt market forces.
As a result, banks face fierce competition from nonbank companies and
other banks who can enter their territory. With increased pressure, banks
have a greater incentive to exploit new sources of revenue. The record
level of profits that banks earned at the start of the decade have been
maintained in recent years, in significant part, because of this emphasis
on noninterest income (for more details see "Record
bank profitability: How, who and what does it mean?" in the April
1998 fedgazette.

Unique characteristics of noninterest income

Banks also seek to increase noninterest income because it is considered
to have traits that make it different from interest income and thus
desirable. In particular, noninterest income could lead a bank to
be less risky if it leads to greater diversification. In addition,
noninterest income is typically described as more steady or stable
than interest income.

Some simple analyses of noninterest income

Adding noninterest income to a bank's revenue stream could reduce
risk by giving the bank a more diversified portfolio of revenue
producing activities. This diversification would only be achieved,
however, if changes in interest income are not associated with changes
in the same direction and of the same magnitude for noninterest
income. The degree to which two quantities are related to one another
can be determined by measuring the correlation between them. Such
a measurement shows that, over the last 15 years, movements in net
interest and noninterest income sources are essentially uncorrelated
(that is, the correlation statistics are very close to zero). As
a result, banks that add noninterest income could be diversifying
and hence becoming less risky.

It is important to note that these aggregate measures do not indicate
precisely how a given bank uses noninterest income. It is possible that
in any individual case, a bank is not decreasing its risk through its
noninterest income activities. For example, the bank could choose a particular
fee income activity where the income moves in the same direction and by
the same magnitude as its income from loans.

Noninterest Income Share of Net Revenue

There have been other claims made about the uniqueness of noninterest
income beyond its risk-reducing abilities. In particular, noninterest
sources are often described as providing a more stable source of income
than net interest sources. Stable can mean several things in this context.
First, in a statistical sense, stability relates to how a quantity (whether
it is the temperature or stock prices) varies around its average value.
But, under this measurecalled the standard deviationnoninterest
income is more variable than net interest income. Specifically, the standard
deviation of the growth rate of noninterest income between 1984 -1999
was significantly larger than that of interest income.

Second, stable could mean that noninterest income will be less likely
to move in synch with economic variables such as interest rates or gross
domestic product. We find that when interest rates are increasing, noninterest
income falls and vice versa. At the same time, the correlation between
interest income and the same interest rates turned out to be almost 0,
implying that there is no linear relationship between the two. In contrast,
changes in GDP are positively correlated with changes in interest income
and a negative correlation exists between noninterest income and GDP.
So when the economy slows, and with it interest income, noninterest income
actually increases and acts as a revenue buffer.

Noninterest Income Components

Finally, observers could also use stability to mean that noninterest
income compensates for declines in banking conditions. We try to
measure that by examining how these two sources of income move in
relation to loan losses. For instance, if noninterest income grows
at faster rates when losses are increasing, the heightened levels
of noninterest income would steady banks' revenue stream and help
the industry better weather the uptick in losses. Both the growth
rates of interest income and noninterest income had a correlation
close to 0 with respect to changes in total loan losses. This implies
that both types of income are similar and do not have a clear relation
to loan losses.

Conclusion

The growth of noninterest income, in particular from fee sources,
has altered the revenue sources for banks. These trends have been
associated with record profits and represent the exploitation of
new technologies and legal regimes. Moreover, there is the potential
that adding fee income into the mix will reduce the risk of the
bank by enhancing its diversification (although other claims about
noninterest income merit more skepticism).

Definitions of Noninterest Income

Source of Noninterest Income

Examples

Income from Fiduciary Activities

Income from trust department transactions
and services

Trading Revenue

Income from exposure to financial instruments
relating to commodities, foreign exchange, interest rates, and equity
securities and indices